EBS - Practice MCQs Solutions

Practice MCQ questions – Solutions

1 A - Exercise value = S0 – X = 593 – 600 = 0, because the option can

never have a negative value.

2 D - Payout ratio = dividend/earnings, eg, 5p dividend, 20p of earnings,

payout ratio is 0.25, or 25%. If the company has unstable earnings, but a
dividend that is showing steady growth, then the payout ratio will be
variable from period to period, so A is correct. This means that B must be
wrong.

If you have a stable payout ratio, eg 25% of earnings will be paid out as
dividends, then if earnings are volatile, it means the dividend will be
unpredictable as well, so C is correct as well.

3 A - For puts the value is ascertained by X – S0, here this will be 350 –
358 = 0 (option can’t have a negative value), so you lose what you pay for
the option, ie 5p.

4 D - Call prices rise with higher interest rates, because the right hand part
of the equation is the present value of the exercise price, which is
subtracted. If the interest rate goes up, then this value will fall, meaning
you are subtracting a smaller value, the call is more valuable, so I is
incorrect. II is false, futures have a symmetrical payoff. III interest rate
swaps only involve the swapping of interest payments, it is the currency
swap that involves interest and principal.

5 B - This is a present value of annuity problem. You need the money

today and there are multiple payments. The expression is;

PVA = CF*PVAIFi,n and you tick off the elements you have got in the
question. You have the PVA (£125k), the CF (£39.5k), the number of
periods (4). The only missing item is i, so we rearrange the formula;
PVAIFi,4 = PVA/CF = £125,000/£39,500 = 3.1646

This is the PVAIF factor, which you would look up table 2 in the text
appendix (you get these tables in the exam). If you read along row 4 (for
the periods) until you get close to 3.1646, then read up for the interest rate.
This is 10%.

6 C - You need to work out the expected return first; return * probability.
Then you want to work out the deviation away from the expected return
for each of the observations. Because this contains negative numbers we
square the deviations (if you simply add up the deviations you get 50). We
take the squared deviations and multiply by the probability. Add these
numbers. This gives the variance, which we take the square root of to give
the standard deviation (because we had squared the deviations earlier in
the calculation).

-1-
EBS - Practice MCQs Solutions

rtn*prob
rtn prob =Exp rtn rtn - Er (rtn-Er)^2 prob(rtn-Er)^2
500 0.1 50 -125 15625.0 1562.5
550 0.2 110 -75 5625.0 1125.0
600 0.4 240 -25 625.0 250.0
725 0.2 145 100 10000.0 2000.0
800 0.1 80 175 30625.0 3062.5
1 625 Variance = 8000.0
Std Dev = 89.44

7 C - The rightist or traditional view on dividends favoured the payment of

large early dividends, this was the ‘early resolution of uncertainty’. The
early dividend was preferred to an uncertain dividend in the future (if the
company retained the earnings and invested).

8 B - The equity in a geared company can be regarded as a call option. The

most sensitive option variable is the volatility. If an asset becomes more
volatile, the option increases in value, so a fall in volatility will reduce the
value of the geared company.

9 A - This is a future value problem. You need the money in the future and
there are multiple cash flows, so it is a future value annuity problem.
Write out the expression FVA = CF*FVAIFi,n, in the question we have
FVA (£70k), i (8%), and n (6 years), we are missing the CF, so rearrange
to solve for the missing CF;

CF = FVA/FVAIFi,n you get the annuity factor from table 4, text

appendix.

CF = £870,000/7.3359, but because you are starting the saving today, this
becomes an annuity due and you need to multiply the annuity factor by
(1+i) to reflect that fact.

CF = £870,000/7.3359*1.08

CF = £870,000/7.92277 = £8,835

10 C - The PV of the cash flows is 161.5, the PI is 161.5/120 = 1.346.

11 C - You use interest rate parity to calculate this. The formula is;

Forward = (1+Forn i/r)/(1+Domestic i/r) * spot exchange rate

Where the Domestic interest rate is the interest rate of the country with the
single unit in the quote. Here the domestic currency is the $. The
calculation is;

1.05 * 0.5263 = £0.54178/$1

1.02

-2-
EBS - Practice MCQs Solutions

12 A - You need to build up a beta for the project. First you need to work
out the ungeared beta for the parent company;

βu = (βe*E/V) + (βd*D/V)

βu = (1.4*0.75) + (0.15*0.25) = 1.0875

This is the ungeared beta for the company, but this does not represent the
risk of the project. The project has a different risk profile to the parent, so
we need to adjust for the revenue volatility and fixed cost differences
between the parent and project.

Project beta = βu * Project revenue volatility

Company revenue volatility

= 1.0875 * (1.2/1.4) = 0.932

Then we need to adjust for the fixed costs;

Project beta = adjusted beta * (1+project fixed costs)

(1+company fixed costs)

= 0.932 * (1.4/1.5) = 0.870

This is the ungeared beta for the project and would be used to work out the
WACC for the project (used directly if the project is funded with 100%
equity. If debt is used, you would be given a debt beta in the question (this
would be a case question, not an MCQ) and you would have to work out
the equity beta and then these would be used to calculate the costs of
equity and debt).

13 C We need to work out the change in net working capital. Current assets
are regarded as cash outflows, they are a use of cash, whereas current
liabilities are effectively a source of cash, you are not paying the bills
today, they are delayed.

If we subtract; CL – CA, we get

-5000, -7250, -6500, -750 for years 0 – 3.
We need the change in net working capital, so;
For year 0 = -5000, for year 1 the change is an additional 2250, so -2250,
for year 2, the change is a fall of 750, so we don’t need so much working
capital, this is a positive, +750, and then for the final year, there is a fall of
5750, so +5750.
The entries will be -5000, -2250, 750, 5750, so for year 2 the entry will be
750.

-3-
EBS - Practice MCQs Solutions

14 B (1+R) = (1+N)/(1+I) = 1.09/1.05 = 1.038095 for the first year,

1.105/1.05 = 1.05238 for the second year. The real return for the two
years is expressed as an annualised rate, so we multiply 1+ the real
returns together and take the square root to get the annualised rate.
1.038095*1.05238 = 1.09247, square root = 1.0452 = 4.52%

15 D The YTM will be greater than 6% because you will make a gain on the
bond. Use the rough and ready YTM to get an estimate of the rate (annual
income on bond +or- the annual capital gain on the bond). The gain is 7.4
over 4 years = 1.85 per year. Add this to 6% = approx 8%. Use 8% to
discount the cash flows, this gives 93.38. This means 8% is too low. The
YTM is above 8%, but probably not by a large amount. 8.92% is too high,
but you may have to discount with this to confirm. The actual YTM is
8.246%, which is none of the above.

16. B, 1.94.
Adjust for revenue volatility;
Rev adj  = u * (New div rev vol/ company rev vol)
= 1.6 * (1.4/1.2)
= 1.867

Adjust for fixed costs

New div u
= rev adj u * (1 + New div fixed costs % / 1 + company fixed cost%)
= 1.867 * (1.30/1.25)
= 1.94

17. A. Use put-call parity

Put + underlying share value = Call + PV exercise price
Put = Call + PVX – S0
Put = 42 + 600/1.060.25 – 615
Put = 18.3p

18. D, r= (D1/ P0) + g

= (20/500) + 0.10
= 0.14

19. C, the value of the firm is not affected by the capital structure.

20. D, divs are taxed, investors incur transactions charges if they have
to sell their shares to raise cash, and the company faces flotation fees if
they sell new equity.

21. B, $1.35, the formula is fwd = (1+Forn)t/(1+Dom)t * Spot rate

1.015 /1.030.5 * $1.36 = $1.35/€1.
0.5

-4-
EBS - Practice MCQs Solutions

22. C, maintaining purchasing power across time requires that the

expected spot exchange rate be consistent with the inflation expected
in the two countries.

23. B, (1.093)5 / (1.087)3 = 1.2145, this is a two year return, need to

express as an annual return, take square root = 1.102. Two year
forward rate starting in three years = 10.2%. Rule for id of fwd rate
notation: first number is the start date (in this case year 3), second
number is the length of the forward rate period (in this case ‘two year
forward rate’). The notation is 3f5 (the 5 is simply the two year length
of the forward rate being added on to the start date).

24. C, (1.07)2 / 1.05 = 1.09038 = 9.04%

25. B, net fixed assets are part of the long term assets of the company,
working capital focuses on assets & liabilities of under one year in
length.

26. B is the correct answer – apply the following formula;

£r = [(2*£D*£T)/i]0.5 where D = cash sum, T = transaction cost, i =
interest rate.

27. C is the correct answer. Use formula 10.2 as shown below;

Expected cash balance change (c) 10000

Transaction cost (T) 90
Interest differential (i) 5%
Minimum cash balance (£M) 80000
Number of times cash balance can change in 1 day (t) 1
s^2 = £c^2 x t 100,000,000

£R = [(3xTxs^2)/4(i/365)]^0.33 +£M 116,661

Upper limit £U = £M+3(£R-£M) 189,984

28. C is the correct answer. First you need to calculate the interest cost of
not taking the discount.
This is i = [1+(discount%/1-discount %)]365/discount days - 1

Inserting the numbers, [1+ (0.02/1-0.02)]365/30 – 1 = 27.865%

The cost of not taking the discount is 30/45 * £300,000 * (0.27865 –
0.08) = £49,729

29. A is the correct answer. The formula is Beta = σjρjm/ σm ie, the
standard deviation of the stock times the correlation of the stock and
the market, divided by the standard deviation of the market. In the
question you are given the variance of the market, so you need to take
the square root to get the standard deviation.

-5-
EBS - Practice MCQs Solutions

30. B is the correct answer. This is an EPS-EBIT problem. We take the

EBIT and subtract the interest payment (80*0.05 = 4), giving the pre-
tax income. Tax this at 30% leaving the after tax earnings. Divide this
by the number of shares (60m) to give 4.1₵ as the answer. The
dividend is not relevant to the calculation. The dividend is paid out of
earnings (eps).

Debt 80
Interest rate 5%
EBIT 7.5
Interest -4
Pre tax 3.5
Tax -1.05
After tax earnings 2.45
Shares 60
EPS 0.041

31. C is the correct answer. The bond cash flows are £7 for the first three
years and £107 for year 4. These are discounted by the relevant
interest rate for each year, eg, £107/1.084.

32. D is the correct answer. The effective interest rate is (1+(i/m)m - 1,

where i is the interest rate and m is the number of compounding
periods per year. Here it is (1+(0.07/365))365 – 1, which equals 7.25%.
To find out the sum just put the cash sum in front of the brackets and
raise the value to mt, where t is the number of years (don’t subtract 1 at
the end of the calculation – that works out the interest rate, what you
are doing here is working out the compound growth factor).

£8000*(1+(0.07/365))365*4 = £10,585.

33. C is the correct answer. The equity weight is 67% and the equity beta
is;
Bu = (Be*(E/(E+D))+(Bd*(D/(E+D)), solve for Be, which = 1.6925.
Now you can calculate re = 4% +1.6925(6%) = 14.155%.
The debt rate is 4% + 0.2(6%) = 5.2%.
Then calculate WACC
WACC = (0.67*0.14155) + (0.33*0.052)*(1 – 0.30)
WACC = 0.106852 = 10.69%

-6-
 EBS - Practice MCQs Solutions

34. A is the correct answer. The is an equivalent annual annuity problem

and we need to work out the PV of the annual running costs, add this to
machine cost and divide by the annuity factor for each machine. As
shown below;
operating Annuity
Years cost costs Annuity 10% factor
A 3 10000 2000 1 0.909091
B 5 13000 1500 2 0.826446
WACC 10% 3 0.751315 2.486852
PV Total EAC 4 0.683013
PV cycle A 14974 6021 5 0.620921 3.790787
PV cycle B 18686 4929

35. A is the correct answer. The lease cash flows are; + Equipment value
(not buying it), - Depreciation tax shield (don’t get it if you lease), -
Lease payment (you need to pay this annually for the equipment), +
Lease tax shield (you get a tax break on the lease). Net these off and
multiply the lease cash flows (excluding year 0 equipment) by the five
year present value annuity factor for the after tax cost of debt (7%).
This give you £651, it is positive, so the PV of the lease cash flows are
lower than the cost of buying, so you should lease the equipment.

0 1 2 3 4 5
Equip 10000
Depn tax shield -600 -600 -600 -600 -600
Lease pmnt -2400 -2400 -2400 -2400 -2400
Lease tax shield 720 720 720 720 720
Lease cash flows 10000 -2280 -2280 -2280 -2280 -2280

The cost of capital for the lease is the after tax cost of debt = 10% * (1- 0.30) = 7%

NPV of lease = 10,000 + (PVAIF 7%, 5yrs * -2280)

= 10,000 + (4.1002 * -2280) = £651.

-7-